North America’s population in the 19th century spread from east to west, driven in the main by farming. And where farmers planted themselves, so grew a demand for farm credit, and eastern bankers followed them.

Drought and crop failure repeatedly parched farmers’ credit, and their bankers’, and when fresh credit got tough to get, the farmers turned to government for help. Here, farm economics and politics led to the 1920s’ Canadian Farm Loan Board, created to offer mortgages to respond to a perceived lack of credit for Western farmers.

The Farm Credit Corporation replaced the board in 1959, with a broader mandate that included consulting services for farmers. The former board operated mostly on a for-profit basis, but FCC’s lending rate was set at 5%, well below profitability, amounting to an interest rate subsidy to farmers. By the 1970s, as the corporation’s losses mounted, interest rates were set at “the cost of funds plus 1.25%.”

FCC’s scope expanded again in 1993, with the Farm Credit Corporation Act. The new Act allowed FCC to finance farm-related enterprises, and bigger farms. It did not limit FCCs activities to filling gaps left by the private sector. These steps — the shift from for-profit to subsidized farm credit, and the expansion to areas where there was no clear market failure — signaled departure from FCC’s original credit-gap mandate. Changes in 2001 allowed FCC to offer more of financial and business management services, and widened FCC’s potential clientele to include more farm-related businesses, including those not farmer-owned. And FCC has seen tremendous growth: Its share of farm debt grew from about 14% in 1992 to 29% by the end of 2011.

FCC’s share of farm debt stands against that of all chartered banks, which hold 36%, and all credit unions, which hold another 16%. FCC has expanded its activities, enlarged its capital base to do so, and built market in a field where the private sector is historically competitive.

FCC’s success owes much to its low capital costs. Capital is in part provided by government, and it borrows directly from the federal government on terms that reflect Ottawa’s credit quality. It does not face the same regulatory capital requirements as other financial institutions, and pays no corporate income tax. And FCC’s loan offerings and terms are different from others’. FCC loans tend to have long amortization periods, higher loan-to-value ratios, and the corporation stands at least as ready as others to lend against supply management (dairy and poultry farm) quotas and to offer interest-only loans. It finances farmers who sign Ontario “green energy” supply contacts. Other offerings seem likely to encourage debt and inflate farm asset values:

The Capacity Builder Loan, to finance quota purchases or livestock, with an option to capitalize interest (in turn, deeply investing FCC, and federal taxpayers, in maintaining the farm quota system).

None of these is inherently inappropriate, but they are risky, in much the same way that so-called subprime mortgage lending is risky. Loans characterized by low down payments or that have high loan-to-value ratios, or that capitalize early accumulations of interest due, or involve balloon or variable future payments, have a higher default rate than more traditional loans.

Now, lending under such risky conditions carries an interest rate premium. For small business lending, a typical risk premium might be 300 basis points above prime. Of course, FCC does not charge such a premium and, unsurprisingly, its relatively risky loan books carry an impairment ratio that exceeds its competitors’. And risks have been growing alongside farm indebtedness as a percent of net income (see graph).

The implications are simple but serious: FCC competes with private-sector lenders in offering financing services to farmers and others; its market share has been growing without a regulatory capital constraint; and farm lending has grown relative to farm income, an indicator of rising risk in the sector. The increased financial risks also appear on the asset side of farms’ balance sheets. The values of farms and buildings, and farm quota values, have shown effervescent increases in recent years, in per-acre terms and as a percentage of farms’ total assets (see graph). And FCC’s lending has grown even faster than farm asset values.

Of course, credit tends to drive asset prices, and increases tend to be followed by sharp revaluations. Recent farm debt growth, coupled with FCC’s aggressive strategies, warrants closer examination by regulators and taxpayers. The potential impacts are not only related to FCC: Its market pressure pushes private lenders to adjust their own lending standards, to remain competitive.

Canadian regulators need to monitor the situation more closely. FCC, as is the case for the BDC and EDC, is not formally subject to a prudential regulator. As a starting place, FCC should be brought under OSFI supervision.

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